Monday, September 15, 2008

The Role of Regulation: Was FDR a Conservative?

The headlines emanating from Wall Street over the weekend and into this morning reveal just how fragile our financial system has become — and how much we need government to play a role in regulating private enterprise. 

Lehman Brothers, a revered investment bank that was worth nearly $60 billion in February 2007, is filing for Chapter 11 bankruptcy this morning. Its collapse comes barely 6 months after regulators narrowly averted the failure of a similar firm, Bear Stearns, by arranging a federally-backed rescue buyout by J.P. Morgan Chase. And it came just a week after the U.S. Treasury took over the private mortgage lenders Fannie Mae and Freddie Mac. 

During a series of crisis-management meetings over the weekend government officials also helped engineer the acquisition of Merrill Lynch, another storied-yet-troubled firm that many thought was next in the bread line behind Bear and Lehman, by Bank of America. Also on the ropes: AIG, which has seen its market value decline from nearly $200 billion last year to $36 billion at Friday's close, and Washington Mutual, the country's biggest savings and loan institution.  

What Bear, Fannie, Freddie, Lehman, Merrill, AIG and WaMu have in common is ownership of assets that quickly plummeted in value, creating a crisis of confidence that they would be able to honor their debts and raise the capital necessary to meet day-to-day operations. Most of these assets were related to residential and commercial mortgages, which Wall Street financial engineers packaged into "structured securities" -- bonds and loans backed by pools of other bonds and loans. 

The idea behind structured securities sounded good: a debt backed by lots of other debts would spread risk, making it easier to lend money to people and businesses with poor, or subprime, credit. 

What actually happened: structured securities successfully spread risk, but they also increased it exponentially. This is because they sundered the traditional relationship between lender and borrower. In the old days a bank would lend to a homeowner or business and keep the loan on its books -- which meant that if the borrower didn't pay, the bank lost money. Over the past decade or so, intermediaries like Lehman, Bear and Merrill bought oodles of loans from banks and packaged them into securities they then sold to institutional investors like pension funds, mutual funds and hedge funds. These investors thought the bonds to be very safe because they were backed by pools of diverse loans -- some high-quality and some subprime — and typically received AAA ratings from credit agencies like Standard & Poor's (that's a topic for another post). 

Structured securities meant that banks were off the hook if their loans defaulted. Investors would take the hit, not them. As a result, they had an incentive to lend as much as possible, without regard for whether the borrowers could repay the loans. Subprime mortgage issuance ballooned, as did "no-documentation" loans. Then, they defaulted en masse and continue to do so. Holders of these securities — including the investment banks who underwrote them and typically held a portion of the new issues on their books — took gigantic losses.

This is how we got to the point where esteemed, centuries-old institutions simply were unable to raise enough capital to offset the billions in losses they were taking on bad loans and structured debt.

Well, it's part of the story. 

The other part is that the federal government provided a huge assist to those who created the current crisis. The 1999 Gramm-Leach-Bliley Act tore down the wall Congress erected between investment banks and banks that took public deposits following the Great Depression. This separation of riskier activities like investment banking from the taking of deposits from ordinary Americans and using that money to make bank loans helped to prevent the "runs" on banks that occurred following the Crash of 1929. Savings banks (and insurance companies like AIG) were supposed to stay out of the investment banking and brokerage businesses, so that another crash would not threaten the nation's savings. 

Tearing down this wall has had disastrous consequences. It encouraged the culture of reckless risk-taking that fueled the boom in structured securities, enabling the mortgage mess and credit crisis that has taken down four of our biggest financial institutions and counting. 

The point here is that some government regulation of private markets is absolutely necessary to keep capitalism — undoubtedly the greatest system ever devised to provide humankind with the wealth and resources it needs to survive and thrive — from unceremoniously eating itself. Today, the government must step in and clean up an historic mess because it failed to adequately assert itself — in ways that would have been far less intrusive and disruptive to the private sector — in the past.

All this reminds me of a seminar I took in graduate school on the creation of welfare states in industrialized countries. I came away from that course convinced that Franklin Delano Roosevelt, despite the general reputation he has for being the grandfather of the big-government liberal movement in the United States, was actually a conservative. 

Not in the perverted sense that "conservative" is used today, mind you. In its literal sense. He was trying to conserve what was best about America -- free-market capitalism -- by experimenting with massive government intervention in private markets, in response to the unprecedented economic dislocation of the Great Depression. During the Depression there were many radical movements that wanted the U.S. to follow Russia's example and become a communist country. These movements became popular with the working class, preying on their justifiable fears and insecurities, and threatened the continued existence of the U.S. as our founders conceived it. 

FDR positively abhorred this idea, so he used the levers of government to try to soften capitalism's roughest edges, so that it would survive. He created Social Security and unemployment insurance. And he created the Securities and Exchange Commission to police the financial markets and require that companies and brokers disclose important information to investors. And Congress at that time put up a wall between banks and brokerage firms that served the country very well until Big Finance lobbyists pushed to tear it down, giving way to the events you read about in today's papers. 

Incredibly, even as it was not regulating enough, government also was too involved in some aspects of the financial markets. Members of Congress, primarily but not exclusively Democrats, were positively in the pockets of lobbyists from Fannie Mae and Freddie Mac. These companies were created by the federal government many years ago to spur mortgage lending to working-class Americans, but were later permitted to privatize while retaining the valuable public perception that the U.S. Treasury would back their debts and prohibit them from failing. Every time Congress or a presidential administration tried to rein the companies in or eliminate them entirely, their lobbyists would cry foul, accusing the reformers of "opposing homeownership," even though Fan and Fred had moved far beyond their original missions of backing loans to people of modest means. 

The result? Fan and Fred were able to float bonds at more attractive rates than banks and lend at the same rates, making bigger profits because of their association with the government. So they grew their balance sheets with abandon and also bought up huge swaths of the mortgage-backed securities I discussed earlier. And now we own them -- you and me, the taxpayers of America -- because the government did indeed bail them out when widespread mortgage defaults essentially rendered them insolvent. 

In both cases — breaking down Depression-era protections and encouraging the growth of the Fan and Fred time-bombs — politicians time and again chose political expediency or allegiance to ideology over the proper course of action for our country. Let us learn from this example and insist that our leaders do better by us in the future. 

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